Francis D. from Australia likes to bounce different EA ideas off of me. He mentioned in the latest emails a fear of getting whipsawed from a signal that is either long or short.
This type of problem occurs all the time. I first encountered it with a simple strategy that fades price crosses over the moving average. Whenever the price crosses and closes below the moving average, go long. Shorts follow the same rules. It’s the kind of stupid simple range trading strategy that I always advocate.
The example above highlights the same thing that Francis complains about. The price floats around the moving average without going anywhere.
Trades based on the price crossing above the SMA come out near breakeven. Winners occur approximately 66% of the time and are one third the size of losers. Such a strategy neither makes nor loses money when ignoring trading costs.
The vast majority of the winners in the strategy are teeny tiny. The strategy encounters its maximum opportunity whenever it is closest to the SMA. The further away it goes, the more likely it keeps going the wrong way.
Flipping the trades still yields a random outcome. The only difference is that winners drop to 33% accuracy, but the average winner is now 2:1.
The Birth of a Trading Strategy
I always wonder how a scaling strategy might affect the outcome. If the strategy is most likely to win when the opportunity is smallest, what happens when the strategy attempts to reduce its position size as the market moves adversely?
Alternatively, what happens if it takes a pass on all the small winners and scales into positions? Yes, it will scale into losers, but it should also make resulting winners bigger. The question then becomes how to decide the rate of scaling and when to bail out of losers.
Thank you, Francis! A new blog series is born. Now that I’ve decided to scale into trades, I need to choose how and when to do it.
Nothing insightful or special jumped to mind. I’m a visual person, so I spent the better part of this afternoon creating the little chart in Excel using NinjaTrader. What starts out as a simple project always grows on itself. It took nearly 4 hours to get the information and formatting correct.
I care about scaling into trades as the price moves further from the 200 SMA. My instinct from looking at the graph above says I should focus on the inflection point. The curve forms a nice bend around 0.3% away from the SMA. Maybe I can start buying at the inflection point until I get to 0.6% or so.
What do you think I should do?
This series eventually led to a profitable trading strategy. If you’d like to read through the journey, then I suggest reading the articles sequentially